Financial Management Introduction Finance? – Finance can be described as the life blood of business. – Can the terms ‘money’ and ‘finance’ be used interchangeably? – Finance may be defined as the art and science of managing money. – According to the Wheeler, “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”. Types of Finance Finance Public Finance Central Gov State Gov Private Finance Local Bodies Personal Finance Social Finance Business Finance Public Finance – It deals with the study of principles underlying the acquisition and utilization of financial resources by central government, state government and semi governmental bodies. – It is the management of public exchequer. – It focuses on fiscal policy, government revenues, taxation, government expenditure, budget procedures etc. Private Finance – It covers the financial planning of individuals, business organizations and non-profit organizations. – It includes: – Personal Finance: planning and management of personal or family’s financial activities. It includes family budgeting, banking, insurance, retirement planning etc. – Social Finance: Financial planning in social enterprises including charitable organizations, educational and religious institutions. – Business Finance: Activities concerned with planning, raising, controlling and administering the funds used in the business. Maruti Suzuki India Limited, formerly known as Maruti Udyog Limited, is a subsidiary of the Japanese automotive manufacturer Suzuki. It was founded and owned by the Government of India between 1981 until 2003. It was sold to Suzuki Motor Corporation by Government of India in 2003. As of July 2018, it had a market share of 53 percent in the Indian passenger car market. Financial Management – Financial Management is concerned with the procurement of funds, their effective utilization and the management of surplus. Thus, it is a managerial activity that covers the planning and controlling of financial and economic resources of an organization. Central issues in Financial Management – From where to procure funds? (Financing Decisions) – Where to invest? ( long term investment decision – Capital budgeting) (Short term investment decision – Working Capital) - How profit is to be distributed? ( Dividend decisions) Functions of Financial Management – Finance functions can be broadly divided into: – Executive Finance Function – Auxiliary Finance Function Executive Finance Function i. Financing Decisions – Financing decisions are concerned with the procurement of the required amount of funds at most favorable terms as and when required. – It is the decision regarding when, where and how to procure the required funds at lowest possible cost. Executive Finance Function ii. Investing Decisions – Long term investment decisions or Capital Budgeting may be defined as the process of long range planning involving the investment of current funds efficiently in long term assets whose benefit are expected to receive over a series of future years. – Decisions regarding expansion, modernization, diversification, replacement of fixed assets etc. are capital budgeting decisions. – These decisions shape the character of the business as fixed assets are the real earning assets Executive Finance Function iii. Liquidity Decisions – It is also known as Working Capital Decisions. – Working capital refers to the amount required to finance the day to day operations of the business or short term requirements such as purchase of raw materials, payment of wages, rent, taxes etc. – Working Capital Management tries to avoid two dangers – Excessive working capital and inadequate working capital – Thus WCM aims at liquidity –profitability trade off. Executive Finance Function iv. Dividend Decisions – Dividend decisions are related to the management of surplus. Dividend decisions refers to the decision regarding the dividend pay out ratio and retention ratio. – These decisions are to be taken scientifically as it directly affects the shareholders and company. Auxiliary Finance Function i. Supervision of cash receipts and cash disbursements ii. Safeguarding cash balances iii. Safeguarding important documents – ownership of assets (fixed and financial) iv. Safeguarding documents related to procurement of fund v. Maintaining books of accounts as per Companies Act ,2013 vi. Preparation of financial statements as per Schedule III vii. Performance Evaluation viii. Financial Reporting ix. Track the behavior of Share Prices continuously Overview of Financial Management FINANCIAL MANAGEMENT Financial Decisions Financing Decisions Investing Decisions Dividend Decisions Risk-Return Trade Off Maximize shareholder wealth Working Capital Decisions Goals of Financial Management (objectives) – Two main goals of Financial Management are: – Profit Maximization & – Wealth Maximization Profit Maximization – Profit Maximization refers to maximization of profit of the firm. – According to this concept, activities that increase the profit are undertaken and those decreases the profit are avoided. – Supporters of this concept argue that profit is a criterion for measuring the economic efficiency of the firm – Increased economic efficiency leads to efficient utilization of economic resources as well. Arguments in favor of Profit Maximization – Profitability is the barometer for measuring the economic efficiency of the business – Efficient utilization of economic resources – Social interest is protected as their resources are used most efficiently – Profit maximization helps opportunities internally firm to finance investment – Accumulate profits and reserves serve as a cushion during recession, depression and stiff competition – High profitability attracts new investors into the firm – When profits are maximized, shareholders wealth is also maximized. Criticisms of Profit Maximization 1. Term Profit is vague and Ambiguous – It is not clear that whether profit is total profit / earnings per share / profit before tax / profit after tax / short term profit / long term profit / net income etc. – No body knows which profit are to be maximized Criticisms of Profit Maximization 2. Ignores timing of cash flows – In profit maximization, profits earned during different periods are treated alike. – We know due to inflation and uncertainty, money received today has more value than money receivable the next year. So this aspect is ignored. – Project 1: 1- Rs 1,00,000 ; 2 – Rs 50,000 ; 3 – Rs 50,000 – Project 2 : 1 – Nil; 2 – Nil; 3 – Rs 2,00,000 – Which project is the successful project? Criticisms of Profit Maximization 3. Ignores Risk factors – Risk refers to variability of returns – Projects with high variability in profits are risker. – Decisions are mainly made on profits without considering risk elements which then becomes illogical. Criticisms of Profit Maximization 4. Conflicting Interest – Profit maximization concept completely ignores the interest of other stakeholders. – It is considered as immoral as it neglects the social responsibility of the business – Overemphasis on profit may reduce the quality of products Criticisms of Profit Maximization 5. Absence of Perfect Competition – In absence of perfect competition, profit maximization results in concentration of power in limited hands and exploitation of societal resources. – Interest of society can only be preserved in case of perfect competition. • • • • • • National Institution for Transforming India 1st January 2015 Head Quarters : New Delhi Chair person : Prime Minister Vice Chair Person : Rajiv Kumar CEO : Amitabh Kanth IAS • Replaced 65 year old Planning Commission (1950) Wealth Maximization – Wealth maximization refers to the increase in the market capitalization of the firm by increasing the market price of the shares. – Market capitalization = total no of shares x present share price – Wealth Maximization is also known as Net Present Worth Maximization. – Net present worth is the difference between present value of future benefits and the current investment. Wealth Maximization – NPW = Present value of future benefits – Initial Investment – If NPW is positive, it means that wealth of shareholders is increased which will eventually reflect in the market price. – Thus financial manager while taking decisions, should ensure that the decisions should create a positive NPW Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Lets consider an example: Year 0 1 2 3 Cash Flows -1000 400 600 200 Discount Factors @ 10% Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Lets consider an example: Year 0 1 2 3 Cash Flows -1000 400 600 200 Discount Factors @ 10% Discount Factor = 1 / (1+r)^ n Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Lets consider an example: Year 0 1 2 3 Cash Flows -1000 400 600 200 0.9091 0.8264 0.7513 Discount Factors @ 10% Discount Factor = 1 / (1+r)^ n Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Lets consider an example: Year 0 1 2 3 Cash Flows -1000 400 600 200 Discount Factors @ 10% 0.9091 0.8264 0.7513 NPV 363.64 495.87 150.26 Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Lets consider an example: Year 0 1 2 3 Cash Flows -1000 400 600 200 Discount Factors @ 10% 0.9091 0.8264 0.7513 NPV 363.64 495.87 150.26 Comparison 1,009.77 Positive NPV 9.77 Wealth Maximization superiors to Profit Maximization ? – Wealth Maximization concept considers the timing of cash inflows. – Wealth Maximization concept considers the risk factor or the elements of uncertainty in future earnings – Net present worth is very precise and fee from ambiguity – In profit maximization concept, the dividend policy was neglected. The wealth maximization concept considers dividend decisions as it affects the market price of shares Wealth Maximization superiors to Profit Maximization ? – Wealth maximization concept is very much important for the long term survival and growth of the company as it protects the interest of various stakeholders of the business – Maximization of wealth indirectly leads to maximization of profit also Criticisms of Wealth Maximization – It is only a perspective idea and it doesn’t tell how the wealth can be maximized. – Wealth maximization ideology is not socially desirable always. – Some people argue that wealth maximization is nothing but profit maximization added with time value of money and risk factor. – Conflicts between board of directors and owners as this concept is sometimes detrimental to the interest of managers and directors. – More emphasis to the wealth of shareholders. • National Bank for Agriculture and Rural Development (NABARD) • 12 July 1982 • Head Quarters : Mumbai • Chair person : Govinda Rajulu • NABARD supervises State Cooperative Banks (StCBs), District Cooperative Central Banks (DCCBs), and Regional Rural Banks (RRBs) and conducts statutory inspections of these banks Profit Maximization v/s Wealth Maximization Basis Wealth Maximization Profit Maximization Timing of Cash Inflows Considered Ignored Risk Factors Considered Ignored Ambiguity Low High Dividend Policy Considered Ignored Concept Broad and Rational Narrow Perspective Economists’ Perspective Accountants’ Perspective Discounting Principle Applicable Not Applicable Role of Finance Manager CFO Treasurer Controller Cash Manager Credit Manager Capital Budgeting Manager Fund Raising Manager Portfolio Manager Financial Accounting Manager Cost Accounting Manager Tax Manager Data Processing Manager Internal Auditor Role of Financial Manager – The executive or officer who handles the financial affairs of a firm is called ‘financial manager’. – He is involved in the planning, utilization and control of financial and economic resources of an organization. – In large business organizations, CFO is appointed as Director (Finance). Further there may be treasurer who handles finance and a controller who deals with accounts. Financial Manager as a Treasurer I. Estimating the Capital Requirements: It is the duty of financial manager to forecast the amount of fund required to finance its fixed assets and current assets. II. Financing Decision Finance Manager has to decide the capital structure of the company, the proportion of debt and equity in the total long term capital of the company III. Investment Decision It is he decision regarding the fixed assets management policy. Finance manager should decide the assets in which the funds are to be allocated. Financial Manager as a Treasurer IV. Dividend Decisions: Financial Manager has to take a decision regarding the proportion of net income to be distribute and retained in the business. V. Investor Relations It is the duty of financial manager to maintain good relationship with the investment community to enhance the marketability of shares. VI. Working Capital Management There is an inverse relationship between liquidity and profitability. It is the duty of finance manager to maintain balance between current assets and current liabilities Financial Manager as a Controller I. Tax Management The firm has to use all possible legal ways to reduce its tax liability. The controller is entrusted with the duties of timely filing of returns, payment of taxes etc. II. Financial Accounting Duty of financial manager includes maintenance of books of accounts and preparation of financial statements as per statutory requirements. III. Internal Auditing Financial Manager has to establish a good internal auditing system to eliminate frauds and misappropriations of goods and cash Financial Manager as a Controller IV. Reporting to Government Finance Manager has to coordinate the preparation of various reports to be submitted to corporate affairs, SEBI etc. V. Finance Control Finance Manager is also entrusted with the duty of comparing actual performance and planned performance. Tools like financial statement analysis, budgetary control etc. are used for this purpose. Scope / Evolution /Approaches of Financial Management – Traditional Approach Traditional approach covers the following aspects: i. Procurement View: Traditional finance emphasize more on procurement of funds from financial institutions (term loans) and capital markets (equity, preference, debentures etc.) ii. Relationship View: Gave more importance to accounting and legal relationship between supplier of funds and firm Scope / Evolution /Approaches of Financial Management iii. Maintenance of Records: Finance Managers were expected to do the lower level functions such as maintenance of financial records and performance reports. Iv Limited Role : Finance function was not part of the regular managerial operations. Finance manager has limited role to perform as his service was sought only in the events of merger, consolidations, reorganization of business etc. Scope / Evolution /Approaches of Financial Management Traditional Approach was severly crticised because of following reasons. i. Ignored the allocation aspect: More focused on procurement of funds. Finance manager was not allowed to take decisions regarding allocation or utilization of funds ii. Outsider-looking Approach: Outsiders such as banks and other suppliers of funds got dominance in the financial decision making process. iii. Lack of Scientific Approach: Relationship between risk and return was completely neglected. Lack of advanced financial models Scope / Evolution /Approaches of Financial Management Traditional Approach was severly crticised because of following reasons. iv. Ignored Working Capital Management: Due to over emphasis on long term financing, it ignored short term liquidity management. v. Ignored Routine functions: Financial Manager has only limited role to perform as his service was sought only in case of events like mergers, consolidations etc. vi. Ignored Cost of Capital: There was no comparison between return and cost of capital. Scope / Evolution /Approaches of Financial Management – Modern Approach Modern approach gives importance to both procurement and allocation of funds. Modern approach addresses the following questions: – Financing decisions – Long term investment decisions – Short term investment decisions – Dividend decisions – Financial Control decisions Importance of Financial Management 1. Financial Planning Financial management helps to quantify the financial requirements of a business concern well in advance. It is the duty of financial manager to ensure that adequate funds are available for investment. For this, various budgets and estimates are prepared. 2. Acquisition of Funds Financial management involves the acquisition of required funds for allocation into various projects. Proper analysis of various financing option helps the firm to acquire funds at low cost. Importance of Financial Management 3. Efficient Utilization of Fund Proper utilization leads to improved operational efficiency of the firm. Increased operational efficiency brings additional profits or reduces cost. This leads to shareholder value maximization. 4. Scientific Financial Decisions Finance managers use techniques ranging from ratio analysis to advanced financial models for making sound decisions. Financial decisions have its impact on the entire business operations. Importance of Financial Management 5. Incresed Profitability Profitability is primarily a function of the effectiveness of funds employed in assets. Financial management helps to improve the profitability position of the firm by using strong control devices such as budgetary control, ratio analysis and cost volume profit analysis. 6. Wealth Maximization If there is no proper financial management system, it will ultimately lead to lower profitability. Lower profitability is an indication of inefficient utilization of funds. This reduces market prices of shares and affect the wealth of investors. Importance of Financial Management 7. Smooth Functioning of Business Working capital management is an integral part of financial management. It ensures adequate working capital, optimum inventory and optimum cash balance so that production and sales processes are not interrupted. 8. Dividend Policy Financial Management helps the firm to manage the surplus of the firm to suit the needs of both company and shareholders. An optimum dividend policy make the investors satisfied. FM and other disciplines – Financial Management is not an independent branch of study. It is an integral part of the overall management. The relationship between other branches of studies includes: – Finance and Economics – Finance and Accounting – Finance and Taxation – Finance and Marketing – Finance and Quantitate Techniques – Finance and HRM Finance & Economics – While considering important financial decisions, economic analysis is also require. – Before taking long term investment decisions, the finance manager should consider general economic conditions, inflation, banking systems. Fiscal policy of the government etc. – All these matters comes under the purview of macro economics. – Micro economics – Production theory, cost analysis etc. Adam Smith Father of Economics Finance & Accounting – Accounting can be viewed as a sub unit of finance as the accounting department supplies necessary information to take sound financial decisions. – Many of the finance functions cannot be performed without accounting – For taking dividend decisions – net income of the business is to be known. – Finance managers also use cost and management techniques like break even analysis, budgetary control etc. Luca Pacioli Father of Accounting Finance & Taxation – Almost all financial decisions involve taxation. Both direct taxes and indirect taxes have a major impact on financial decisions. – While considering dividend decision, firm has to consider Dividend Distribution Tax (DDT) – Deciding debt equity mix – interest on debt is a tax deductible item. – Long term investment decisions – impact of depreciation cannot be ignored. James Wilson Father of Income Tax Finance & Marketing – When a firm needs to introduce a new product, its cost benefit analysis has to be done. This need the help of the finance department. – Inventory decisions and receivables management which are related to marketing department are also executed by the finance department. Philip Kotler Father of Marketing Finance & Quantitative Techniques – One of the basic principle of finance is ‘discounting’. – Compounding and discounting are treated as mathematics of finance – While taking decisions under uncertainty and risk, finance considerably draws inference from quantitative techniques. – Techniques used as standard deviation, probability analysis, simulation method etc. Finance & HRM – Human resource represents one of the important assets of an organization though not disclosed in the balance sheet. – Firm has to incur a considerable amount for the purpose of recruitment, training etc. – To create a sound HR policy, comparison of expenditure incurred and labour productivity should be done. – Further finance department also decides the wage structure, incentives etc. Elton Mayo Father of HRM Inter-relationship between financial decisions – Investment decisions are affected by financing decisions? – Financial manager has to plan the pattern of financing – Financing decision is related to investment decision? – How the procured funds are invested, what should be rate of return. – Dividend decision to Financing and Investing decisions? – Company earn profits by investing in profitable projects – If a company retain the profit that could be used as internal source of financing Inter-relationship between financial decisions – How working capital decisions are relate to others? – Raising of funds through long term sources increases the liquidity – Payment of dividends affect the liquidity RISK-RETURN trade off – Financial management aims at wealth maximization through maximization of market price of shares. – These decisions are affected by risk-return characterstics. – When firm uses debt in the capital structure, the risk of payment of interest exists. – However it will increase the returns of shareholders as debt is a cheaper source of finance. RISK-RETURN trade off – When firm distributes its profits among shareholders, it may increase the market price of shares as shareholders return increases. – On other hand, risk of liquidity arises for the company due to lack of funds. – Thus wealth maximization is possible only when there is a trade off between risk and return. – Risk-return trade off refers to a balance between risk and return that maximize the value of the firm. – Meaning of Finance – Types of Finance – Financial Management – Meaning – Functions of Financial Management – Goals of Financial Management – Difference between Profit Maximization and Wealth Maximization – Role of Financial Manager – Scope of Financial Management – Importance of Financial Management – Financial Management and other disciplines – Inter-relationship – Risk Return tradeoff